Wednesday, June 10, 2015

A unicorn is a magical beast, a horse-like, horned creature that is so rare, that even in mythology, you almost never run into a blessing of unicorns (which, I have learned is what a group of unicorns is called). It was perhaps the rarity (and magic) of private businesses with billion-dollar valuations that led Aileen Lee, founder of Cowboy Ventures, to call them unicorns, in 2013, but as their numbers increase by the month, it may be time to rename them after a species that is more common and less magical. While there are several provocative questions that surround the rise of unicorns, this post is dedicated to a very specific question of how the investor protections that are offered to venture capitalists at the time of their investments can not only affect the measurement of value and make non-unicorns look like unicorns but also skew the behavior of both investors and owners.

A Blessing of Unicorns
One of the best visuals that I have seen on the rise of Unicorns is in this Wall Street Journal article, and it not only allowed you to see the rise of individual companies but compare the numbers over time. In June 2015, there were 97 companies that had values that exceeded a billion, with Xaomi and Uber leading the list, with valuations in excess of $40 billion. The breakdown of Unicorns globally is captured in the pie chart below:

Source: Wall Street Journal

Not surprisingly, the vast majority of unicorns are US-based, though the number of Asian entrants into the ranks is increasing. Looking at the sectors across which these unicorns are sprinkled, the WSJ article provides the following breakdown:

Source: Wall Street Journal

The explosion in the numbers of these companies has also given rise to almost as many explanations for the phenomena, some based on rationality and some on the prevalence of a bubble. The rationality-based explanation for the surge in unicorns is that it has become easier to remain a private business, as private capital markets broaden and become more liquid, while it has become more costly to become a public company, with increased disclosure requirements and pressure from investors/analysts. The less benign argument is that investors are being driven by greed to push up the prices of young companies and that this has all the makings of a bubble. I think there is truth in both arguments and that you can have both good reasons for the increased number of large value private businesses and momentum driven froth in the market. However, I will leave that discussion to those who know more about these young companies than I do, and are more confident in their capacity to detect bubbles than I am.

Breaking the Unicorn barrier
If the conventional definition of a unicorn is a private business with a valuation that exceeds a billion, how do you arrive at the valuation of such a business? While you have no share prices or market capitalizations for these companies, you can extrapolate to the values of private businesses, when they raise fresh capital from venture capitalists or private investors. Thus, if a venture capitalist invests $100 million in a company and gets 10% of the ownership in the company in return, we estimate a value of $1 billion for that company, making it a Unicorn. There are, however, two problems that get in the way of a good estimation. One is that the capital infusion changes the value of the company, creating a distinction between pre-money and post-money values. The other is that the investor's equity investment generally comes with bells and whistles, designed to protect the investor from downside risk and these protections can skew the value estimate.

1. Pre versus Post Money
In an earlier post on the offers and counter offers that you see on Shark Tank, the show where entrepreneurs pitch business ideas and ask competing venture capitalists for money, I drew the distinction between pre and post money valuations. If the capital raised in an offering is held by the company, rather than used to pay down debt or owners's cashing out, the value of the company increases by the amount of the new capital raised, leading to the following distinction between pre-money and post-money values.

In the example above (where an investor invests $100 million for 10% of a firm), the post-money value is $1 billion but the pre-money value is only $900 million. Thus, companies that are smaller than a billion can make themselves look like billion dollar companies, if they are willing to give up enough ownership in the company and can find investors with deep pockets.

While it is unlikely that you will be able to find an investor to offer $950 million in capital for a business with a $50 million valuation, it does illustrate why post money valuations may not always be comparable across businesses.

2. Investor Optionality

While the difference between pre and post money valuations is easy to handle, there is another aspect of venture capital investing that is more messy. Many venture capital investors are offered protection against downside risk on their investments, though the degree of protection can vary across deals. What type of protection? Consider the investor who invested $100 million to get 10% of the company in the example above. That investor's biggest risk is that the value of the business will drop and that investors in subsequent rounds of capital raising or in an initial public offering will be able to get much better deals for their investments. To protect against this loss, the investor may seek (and get) a provision that allows his or her ownership stake to be adjusted for the lower value. With full protection, for instance, if the value of the business drops to $500 million on a subsequent capital event, the original investor's ownership stake will be adjusted up to 20% (reflecting the lower value). This is termed a full ratchet. Alternatively, in the weighted-average approach, the original investor will receive partial protection, resulting in an ownership stake between 10% and 20% if the value drops to $500 million, depending on how the weighted average ownership stake is computed. The key, though, is that this provision is protection against a value drop, but only if the company seeks out capital, and is thus contingent on a capital event occurring.

The protection is usually stated in terms of price per share, where the price per share of the investor's original investment is adjusted to reflect the price per share in the new round of capital, but it is effectively a protection of your original dollar investment and it is easiest to think of this protection as a put option on your investment. In the full ratchet case, assuming a capital event occurs, you are effectively protecting your initial dollar investment, at least until the value of the business hits $100 million (at which point you would be entitled to 100% of the business). Once the value of the business drops below $100 million, the protection can no longer be complete and the pay off diagram for this investment, as a function of the value of the business, is below:

Note that the protection works fully when the value of the business is between $100 million and $ 1 billion and only if there is a capital event to trigger it. To value this option, you need three more pieces of information:

Probability of capital event: Since a capital event is the trigger for the protection, there will be no protection if no capital event occurs, a scenario that will unfold if the business unravels quickly. Put differently, the protection is useless if the business never raises any additional capital. (Since the probability of accessing new capital will decrease as the value of the business drops, especially if the drop occurs quickly, the option value is likely to be overstated.

Expected time to capital event: The timing of the capital event may not be known with certainty, but to the extent that it can be forecast, you need an expected value. If the protection covers multiple capital events, it is the expected time to the last one.

Degree of protection: Depending on how it is structured, the protection offered an investor can range from 100% (with full protection) of the dollar capital invested to less (with weighted average).

Assume, for instance, that the investor in the example above (who invested $100 million for 10% of the business) if offered complete protection in an anticipated IPO of the company and assume further that there is a 90% chance of the IPO occurring in one year. For the standard deviation, I used the industry average standard deviation of 72.48%, derived from publicly traded stocks in the online software business. The expected value (allowing for the 90% chance of a capital event) that I estimate for the protection option, in this spreadsheet, is $25.116 million and the effects on the pre-money and post money valuations are captured below:

Thus, the capital increase pushed up the value by $100 million and the investor protection clause served to inflate the unadjusted post-money valuation from $748.84 million to $ 1 billion. The greater the investor protection offered and the larger the amount of capital raised, the greater will be the disparity between the true value of the business and its perceived value (based on the transaction details). In the table below, I list out the percentage difference between the true value and the perceived value as a function of investor protection and business risk (captured in standard deviation).

For a $100 million investment for 10% of a company, with a 90% chance of a capital event.

Thus, if investors get 95% protection in a business where equity values have an annualized standard deviation of 70%, the true value of the business will be 21.54% lower than the perceived value (which is $ 1 billion, based on the $100 million investment for 10% of the firm).

I know that I have simplified the complex world of venture capital deal-making in this example, and that allowing for more sophisticated protection mechanisms and multiple capital rounds will make it more difficult to estimate the protection value. However, this example delivers the general message that the more protections that are offered to investors at the time that they invest in young start-ups, the less dependable are the simple extrapolations of value (from capital invested and ownership stakes received).

No free lunches

As an outsider with an interest in valuation, I find venture capital deals to be jaw-droppingly complex and not always intuitive, and I am not sure whether this is by design, or by accident. When it comes to investor protection, the stories that I read for the most part are framed as warnings to owners about "vulture capital" investors who will use these protection clauses to strip founders of their ownership rights. I think the story is a far more complex one, where both investors and owners see benefits in these arrangements, and where both can expose themselves to dangers, if they over reach.

Private Company Investors
It is easy to see why private company investors like protections against downside risk, especially when investing in young start-ups, where valuation is difficult to do. However, there are three consideration that investors need to keep in mind, when deciding how much protection to seek.

At a fair price, protection adds no value: In investing, you can, for the most part, buy protection agains the downside (in the form of insurance or put options), if you are willing to pay the right price. At a fair price, the protection delivers peace of mind but no additional value. In the example above, the prices that I computed for downside protection were fair prices and neither the investor nor the owner lose at that price. Thus, an investor can either invest $100 million, with no downside protection, and ask for 13.35% of the post-money value of $748.84 million, or get full downside protection and settle for 10.00% of the artificially inflated post-money value of $1 billion.

Paper Protection: When investing in young start-ups with uncertain futures, the protection clauses in agreements often deliver far less than they promise. The anti-dilution provisions fail if the business you invest in never seeks out additional capital and the liquidation preferences that many investors add to their investments will not provide much respite when these young businesses are forced to liquidated, since their valuations tend to be heavily tilted towards human and idea capital. It should therefore come as no surprise that a significant portion of venture capital investments, promise and protection notwithstanding, yield little or nothing for investors. At the risk of offending some of my readers, I would argue that the protection clauses in most venture capital investments have more in common with the rhythm approach for birth control, a hit-or-miss system that delivers big surprises, than with full-fledged contraception.

Abdication of valuation responsibilities: Venture capitalists who view building in protection against the downside as an alternative to making valuation judgments are seeking false security. As an investor, if I were asked to choose between investing with a venture capitalist who makes good valuation judgments but is not adept at building in downside protection or with a venture capitalist who is superb at building in downside protection but haphazard about valuation judgments, I would pick the venture capitalist who makes good valuation judgments every single time.

There is also the very real concern is that some venture capitalists who believe that they are protected from downside risk (even if that belief is misplaced) may be inclined to take reckless risks in investing.

Founders/Entrepreneurs
There are three benefits to founders and entrepreneurs from granting protection to investors. The first is that they allow them to raise capital in circumstances where its might not otherwise have been feasible. The second is that granting these protections may give the founders/owners more freedom to run the businesses as they see fit, without constant investor oversight. The third is that it allows for inflated valuations, as illustrated in the example above, that can then yield either bragging rights or access to more capital.

The costs are equally clear. If owners give away too much of the firm for bragging rights, they will be worse off. In the example above, for instance, where we estimated the value of protection to be approximately $25.12 million, giving the investors more than 10% of the unadjusted post-money value of the business in return for $100 million in capital invested would be giving up too much. This cost is exacerbated by a behavioral quirk, which is that the founder owners of a business often tend to be far more confident about its future success than the facts merit. The same over confidence and faith that makes them successful entrepreneurs also will lead you to under price the investor protections that they are giving away in return for capital.

Public Market Investors

While public market investors may view these arrangements between venture capital investors and founder owners as an inside-VC game, they can be sucked into the game in one of two ways. The first is when public market investors are drawn to invest in private businesses, drawn by the allure of high returns (and not wanting to be left out). The second is when private businesses go public and investors are trying to estimate a fair price to pay for the offered shares.

In both cases, it is natural to look at the post-money valuations that emerge from prior capital rounds and use those values as anchors in determining fair prices to pay. After all, not only are these real transactions (rather than abstract valuations), but the assumption is that the venture capitalists who were able to invest in these rounds must be smarter and better-informed than the rest of us. I think that both assumptions are shaky, the first because the structuring of the transaction (with investor protection and capital infusion) affecting the observed post-money valuations and the second because any investor group (no matter how savvy it might be) is capable of becoming irrationally exuberant. Investors can take the first steps in protecting themselves by doing their homework. A private company that is planning on going public has to reveal the details of protective clauses and other carry overs from prior capital rounds in its prospectus.

Some unsolicited suggestions
There is nothing wrong with investors seeking protection from downside risk, just as there it is perfectly natural for owners to seek to pump up post-money valuations to make themselves more attractive to new capital providers. The damage occurs when one or both groups let these desires dominate its investing and business decisions. At the risk of sounding presumptuous, I would suggest the following:

Be real: Both sides would be well served by reality checks. Investors have to be recognize that the protection they are getting is porous and contingent on capital raising events and owners have to realize that offering these protections may alter how and when they raise additional capital, perhaps to the detriment of their businesses.

Keep it simple: The only people who gain from complexity are lawyers, accountants and consultants. I may be missing the historical context here, but I think that there are far simpler ways of building in protection than the standards that exist today. For instance, rather than continuing with the practice of adjusting price per share for dilution, which is the practice today, I think it would be far simpler to write the protection in terms of dollar capital invested.

Check the price of protection: At the right price, protection creates value for neither investors nor founder owners. If the protection is priced too high, with the investor settling for a far smaller percentage of the unadjusted value than he or she should, it is not worth it. If the protection is priced too low, founder owners are giving up too much of their businesses in return for the capital raised.

Don't forget your fundamentals: While the presence or absence of protection may make a difference in marginal investments, it should not fundamental change the businesses you invest in, if you are investor, or how you run your business, if you are an owner. Thus, if investors use the presence of downside protection as a reason for investing in over valued businesses, they will lose out in the end. (And making that investment convertible and calling it preferred will not make it a good investment.) By the same token, founders who give away much larger percentages of their businesses than they should, to pump up post-money valuations, will regret that decision in good times, and even more so in bad times.

Wednesday, June 3, 2015

In my last post, I looked at the leavening effect that large cash balances have on PE ratios, especially in a low-interest rate environment. In making that assessment, I used a company with no debt to isolate the effect of cash, but many of the comments on that post raised interesting points/questions about debt. The first point is that while cash acts as an upper for PE, debt can act as a downer, with increases in debt reducing the PE ratio, and that if we are going to control for cash differences in the market across time, we should also be looking at debt variations over the years. The second is the question of which effect on PE dominates for firms that borrow money, with the intent of holding on to the cash. In this post, I will start by looking at debt in isolation but then move to consider the cross effects of cash and debt on PE.

Debt and PE: A simple illustration

To examine the relationship between PE and debt, I went back to the hypothetical software firm that I used to evaluate the effect of cash on PE. Initially, I assume that the firm has no cash and no debt and is expected to generate $120 million in pre-tax operating income next year, expected to grow at 2% a year in perpetuity. Assuming that the cost of equity (and capital) for this firm is 10%, that the tax rate is 40% and that its return on equity (and capital) on new investments is 36%, the company's income statement and intrinsic value balance sheet are as follows:

Now, assume that this firm chooses to move to a 40% debt ratio with a pre-tax cost of borrowing of 4%. The effects of the debt on the are traced through in the picture below:

Note that the value of the business has increased from $850 million to $988.37 million, with the bulk of the value increase coming from the tax subsidies generated by debt.

The effects of borrowing show up everywhere, with almost almost every number shifting, and the effects at first sight seem to be contradictory. Higher debt raises the cost of equity but lowers the cost of capital, reduces net income but increases earnings per share and results in a lower PE ratio, while increasing the value per share. The intuition, though, is simple. Borrowing money to fund the business increases both the expected returns to equity investors (captured in the EPS increase) and the riskiness in those equity returns (pushing the PE ratio down) and at least at a 40% debt ratio, the benefits outweigh the costs. In fact, if you are able to continue to borrow money at 4% at higher debt ratios, the PE ratio will continue to drop and the value per share continue to increase as the debt ratio increases.

Note that at a 90% debt to capital ratio, the PE ratio drops to 2.75 but the value per share increases to $11.41. If it is sounds too good to be true, it is, because there are two forces that will start to work against debt, especially as the debt ratio increases. The first is that the rate at which you borrow will increase as you borrow more, reflecting the higher default risk in the company. The second is that at a high enough debt level, with high interest rates, the interest expenses may start to exceed your operating income, eliminating the tax benefits of debt. In the table below, I highlight the effects on PE and value per share of different borrowing rates:

Numbers in red are declines in value/share

The breakeven cost of borrowing, at least in this example, is around 8.6%; if the company borrows at a rate that exceeds 8.6%, debt reduces the value per share. The effect on PE, though, is unambiguous. As you borrow more money, the PE ratio decreases and it does so at a greater rate, if the borrowing rate is high.

Debt, Cash and PE: Bringing it all together

Now that we have opened to the door to cash and debt separately, let's bring them together into the same company. A measure that incorporates both cash and debt is the net debt, which is the difference between the cash and debt balances of the company.

Net Debt = Total Debt - Cash and Marketable Securities

This number will be negative when cash balances exceed total debt, zero, when they offset each other, and positive, when debt exceeds cash. In the table below, I have estimated the PE ratio for the company with different combinations of debt ratios (from 0% to 50%) with cash ratios (from 0% to 50%), with debt borrowed at 4% and cash invested at 2%:

Numbers in red are declines in value/share

Note that both the cash effect, which pushes up PE ratios, and the debt effect, which pushes down PE ratios, is visible in this table. Interesting, a zero net debt ratio (which occurs across the diagonal of the table) does not have a neutral effect on PE, with PE rising when both debt and cash are at higher values; thus the PE when you have no cash and no debt is 11.81, but it is 12.66 when you have 40% debt and 40% cash. Before you view this as a license to embark on a borrow-and-buy treasury bills scheme, note that the value per share effect of borrowing money and holding it as cash is negative; the value per share declines $0.22/share when you move from a net debt ratio of zero (with no debt and no cash) to a net debt ratio of zero (with 40% debt and 40% cash). Again, there is no mystery as to why. If you borrow money at 4% and invest that money at 2%, which is effectively what you are doing when cash offsets debt, you are worse off than you would have been if you had no cash and no debt. In fact, the only scenario where the value effect of borrowing money and buying T.Bills is neutral is when you can borrow money at the risk free rate but even in that scenario, the PE ratio still increases. In short, the cash effect dominates the debt effect and you can check it out for yourself by downloading the spreadsheet that I used for my computations.

Cash and Debt Effects on PE: US Stocks from 1962 to 2014

In my last post, I noted the difficulty with dealing with cash balances at financial service firms, where the cash serves a very different purpose than it does at non-financial service firms. That statement is even more applicable when it comes to debt, since debt to a financial service firm is less a source of capital and more raw material. Hence, I will focus entirely on non-financial service firms for this section. The first set of statistics that I will estimate relate to debt and cash. In the graph below, I look at cash as a percent of firm value (estimated as market capitalization plus total debt), total debt as a percent of that same value and the net debt ratio (the difference between total debt and cash, as a percent of value) for non-financial service firms in the US from 1962 to 2014.

Raw data from Compustat: All money-making, non-financial service firms

Note the median values for cash and debt are highlighted on the graph. In 2014, the cash holdings at non-financial service companies in the US amounted to 7.30%, higher than the median value of 7.23% for that statistic from 1962 to 2014, and the total debt was 24.20% of value, lower than the median value of 28.39 for that ratio from 1962 to 2014. Since cash pushes up PE ratios and debt pushes down PE ratios, the 2014 levels for both variables are biasing PE ratios upwards, relative to history.

Unlike the cash effect, which I was able to measure with relative ease by netting cash out of the market capitalization and the income from cash from the net income, the debt effect is messier to isolate. If you assume that cash is the only non-operating asset (i.e., that companies do not have cross holdings and other non-operating investments), the debt effect can be computed approximately. First, if cash and debt is zero for a company, and there are no other non-operating assets, the net income for that company will be its after-tax operating income (EBIT (1-tax rate)). Second, the value of the company, if it it had no cash and debt, can be approximated with its enterprise value, leading to the EV/EBIT(1-t) providing an approximate measure of what the earnings multiple would have looked like with no cash and no debt. (The enterprise value does include the value effect of debt and is hence not a clean measure of what the value would have been, if the firm had no debt and no cash.)

Debt Effect = EV/ EBIT (1-t) - Non-cash PE

To estimate these numbers for my sample, I used the average effective tax rate each to compute the after-tax operating income in that year, in recognition of the reality that US companies would not be paying the marginal tax rate on taxable income, even if they had no interest expenses. The graph below summarizes the cash and debt effects on stocks from 1962 through 2014:

Source: Compustat; All money-making, non-financial service US firms

At the end of 2014, the PE ratio was 17.73, the non-cash PE was 16.05 and the EV/EBIT(1-t) was 19.44. So, what do these numbers mean? All three measures are higher than the median values over the last 55 years, which would be ammunition you could use to argue that stocks are overvalued. However, as I noted in my post on PE ratios last year, the treasury bond rate, at 2%, is also much lower than the historic norm, and if you don't buy into the bubble story, could be used to explain the higher multiples. I don't this post is the forum for examining the heft of these arguments, but I did try to provide my views in this post last year on bubbles.

PE Ratios: Three Rules for the road

Like most investors, I like the simplicity and intuitive feel of PE ratios, but they are blunt instruments that can get us into trouble, when used casually. A low PE ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high PE ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios. Based on the last two posts, I would suggest three simple rules for the use of PE ratios.

When comparing PE ratios across companies, don't ignore cash holdings and debt. As the diversity of companies within sectors increases, the old notion of picking the lowest PE stock as the winner is increasingly questionable, since you may be choosing most highly levered company in the sector.

When comparing PE ratios across time, don't ignore cash holdings and debt. In these last two posts, I have noted the ebbs and flows in both cash as a percent of firm value and debt as a percent of value across time, sometimes due to shifts in the numerator (cash and debt values changing) and sometimes due to shifts in the denominator (market value of equity changing). Whatever the reasons, these shifts can affect the PE ratios for the market, making it look expensive when cash balances are high and debt ratios are low.

Any corporate action that changes the cash or debt as a percent of value will change the PE ratio. Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the PE ratio for the company should decrease after the buyback, as (high PE) cash leaves the company. Thus, the practice of forecasting earnings per share after buybacks and multiplying those earnings per share by a constant PE will overstate value. This effect will be even more pronounced, if the company borrows some or all of the money to fund the buyback, since a higher debt ratio will also push down the PE even further.

Finally, if you are at the receiving end of an investing pitch (that a stock or market is cheap or expensive), based just on PE ratios, you should be skeptical, no matter how credentialed the person making the pitch may be, and do your own due diligence.